Credit Is a Cycle: Finding Opportunity in Turmoil

Panel Consensus on Credit Cycle Position:

• Don Mullen and Justin Slack characterize the current environment as the "beginning" of a new distress credit cycle, distinct from previous cycles due to extraordinary fiscal and monetary stimulus.
• Glenn August disputes the notion that the cycle has just begun, arguing that liquid credit markets (high yield at 5%, loans at 5.5-6%) are fairly to slightly overvalued and that the equity/credit markets are signaling confidence in a recovery.
• Amy McGarrity agrees with the sentiment that security selection is currently more critical than sector selection, though she notes significant risks remain in specific sectors like airlines and supply chains.
• All panelists agree that the post-stimulus era has delayed defaults but not eliminated them, with elevated default rates expected over the coming quarters.

Market Structure and Systemic Risk Comparisons (2008 vs. Today):

• 2008 Systemic Trigger: Forced selling occurred because bank loans and high yield were heavily traded via mark-to-market total return swaps and margin calls.
• 2020/2021 Systemic Shield: Bank loan debt is largely housed in Collateralized Loan Obligations (CLOs) which do not have mark-to-market provisions; consequently, there were no forced margin calls when Lehman Brothers collapsed.
• Underwriting Degradation: A decade of demand for floating-rate products drove down underwriting standards, leading to poor quality assets in CLOs similar to the subprime mortgage structure of the Global Financial Crisis (GFC).
• Corporate Leverage: While 2008 featured high leverage in trading books, today's leverage is higher on the corporate balance sheet due to companies prioritizing liquidity over leverage ratios during the pandemic.

Specific Data Points and Market Metrics:

• High yield issuance reached a record $350 billion year-to-date, compared to $270 billion in the prior year.
• Current default rates stand at 6% (up from 2.2% over the last five years), with 45% in oil and gas and 6% in retail.
• Investment Grade (IG) market composition has shifted: 57% of high yield is now BBB-rated (up from 40% in 2008), and over 50% of the IG market is BBB, with $320 billion of "low BBB" debt (up from $160 billion).
• CLO investment criteria are described as "robotic," investing in lower-quality assets in a way that mimics the diversification myths of pre-GFC subprime mortgages.

Investment Strategies and Return Expectations:

• Nimbleness vs. Scale Debate:
  • Don Mullen and Justin Slack argue that mid-sized, nimble managers are better positioned to find alpha in small-to-mid cap distressed opportunities and "orphaned" companies that are too small for large funds.
  • Glenn August counters that scale and capital size are critical for driving bankruptcy processes, controlling outcomes, and providing the liquidity required for large rescue financings and private equity deal support.
  • Amy McGarrity notes that Colorado PERS manages assets in-house to maintain agility but also allocates to opportunistic managers during dislocations, prioritizing trust in process over size.
• Private Credit and Rescue Financing:
  • Glenn August identifies private credit rescue financing as a key opportunity, targeting 8-12% unlevered returns, with rates compressing from 12-14% in early 2020 to around 10% currently.
  • Mullen predicts net returns in residential distress in the high teens to low 20s, and commercial real estate distress could yield mid-20s returns.
  • Slack suggests convertibles are a viable vehicle for achieving double-digit returns due to the technology sector focus and debt-like downside protection.
• Return Targets:
  • Amy McGarrity maintains a long-term strategic return target of 7.25% for the 30-year period, relying on opportunistic sleeves to compensate for lower core fixed income returns.
  • The panel agrees that traditional liquid fixed income yields are insufficient to meet long-term liability-driven investment goals without taking on opportunistic risk.

Sector-Specific Dislocations and Outlook:

• Commercial Real Estate (CRE): Glenn August and Don Mullen foresee significant distress in hotels, retail, and entertainment venues due to secular decline combined with pandemic impacts; they view the market as "early" in the downturn.
• Residential Mortgage: Mullen notes a unique dichotomy where delinquencies are at GFC levels, yet home equity is at record highs (2-3x the GFC levels), mitigating the likelihood of a massive downward spiral in home prices.
• Sector Dispersion: The crisis has created a split within sectors (e.g., resilient retailers vs. collapsing ones), making security selection the primary driver of returns rather than broad sector avoidance.
• Unknowns: Slack and others highlight that the medium-term impact of massive stimulus on inflation and interest rates remains unknown, creating a volatility environment that favors liquid, flexible positions.

Forward-Looking Statements and Decisions:

• Distress Timing: Mullen and Slack expect significant default cycles and distressed opportunities over the next 12-24 months, driven by the unwinding of pandemic-era debt structures.
• Liquidity Constraints: Slack warns that long-duration, illiquid private debt is risky given the unknown macroeconomic variables (unemployment, inflation) and prefers liquid vehicles that allow for rapid reallocation.
• Capital Allocation: McGarrity plans to increase allocations to opportunistic managers and real asset lending to generate returns that outpace the low-yield core portfolio.
• Market Evolution: The panel anticipates a shift toward customized, direct private credit transactions and away from traditional bank loan syndications for large deals.
• Stimulus Limitations: Mullen asserts that fiscal and monetary stimulus will not resolve distress in sectors requiring consumer/business confidence (travel, hospitality, entertainment), predicting a massive restructuring in these areas.